It’s been about four months since we last checked in on hypothetical clients Hal and Stephanie Brown. We assumed that they would have about $7,000 of excess cash flow per month, but Christmas spending and a large vacation have resulted in accumulating only $24,000 during the past four months. Adding that $24,000 to the prior $10,000 emergency fund means that the $34,000 in the emergency fund can cover the $18,000 of credit card debt at 0% interest for the next few months. If a similar deal can be had when the current 0% interest rate expires, then we will consider that option, but if not, now the Browns have the means to pay off that debt in full if necessary. However, the Browns only have a one month emergency fund on top of that (average projected monthly spending is $15,000).

Now that the Browns are eligible to contribute to their 401ks, and given our desire to take advantage of their employer’s match, we need to decide how much to contribute to their 401ks. The Browns’ highest interest rate debt is Hal’s student loans at 7%, which are not deductible because of their adjusted gross income. That 7% interest rate is much less than the 50% and 100% rates of return due to their employer match, not even factoring any investment gains.  In order to take advantage of the full employer 401k match and spread out the contributions over the course of the year, the Browns will need to contribute $1,667 each month collectively, thereby reducing their monthly excess cash flow to $5,333 starting this month.

We should also consider whether to max the Browns’ 401ks this year. Doing so would reduce their excess monthly cash flow to $4,000.  The simple answer is “yes” because the Browns still have excess cash flow to focus on their debts, their emergency fund covers 1 month of expenses on top of the upcoming credit card debt payoff, the 401k is an annual use-it-or-lose-it investment vehicle, and the long-term performance of the stock market (around 10%) is higher than the Browns highest debt at 7%.

The simple answer may be sufficient, but I want to propose a more dynamic analysis to this decision. Using the chart from August 2016, which is reproduced below, I want to create a simple, passive portfolio and then project a rate of return for the whole portfolio. Comparing the historical stock market return to your debts’ interest rates is not an apples-to-apples comparison. This is because 1) most people are not 100% U.S. stocks and 2) most people are highly unlikely to earn the U.S. stock market’s historical rate of return in a diversified portfolio.

real return chart

A middle of the road portfolio may be 40% U.S. stocks, 20% foreign stocks, 10% REITs, 20% US bonds and 10% foreign bonds.  A blended average of that allocation and the above expected real (inflation adjusted) rate of return results in an expected portfolio return of 4.2%.  To compare it to the 7% interest rate debt, we then need to add back current inflation of 1% and subtract my somewhat optimistically low 401k expense ratio of 0.5%, resulting in an expected long-term rate of return of 4.7%. Now, with a true apples-to-apples comparison of 7% interest rate debt to 4.7% projected rate of return on investments, I would suggest to the Browns that they contribute enough to their 401k to get the 100% match and the 50% match, but to not go above that right now while they have a 7% interest debt.  If the markets change such that the Browns’ expected rate of return is higher, especially after the 7% interest debt is paid off (the next highest is 4.5%), then we may want to max the 401ks.

As a result, for at least the next two or three months, the plan is for the Browns to contribute enough to their 401ks to get the full match, and to use their excess cash flow to further build their emergency fund to cover at least two or three months of living expenses. In the next article in this series I hope to further explore how much of an emergency fund the Browns should keep at the present time as well as whether the Browns should use some of their excess cash towards a backdoor Roth IRA for 2016 before the April 15, 2017 deadline. We will also update expected investment returns to see if that changes our analysis.

-Richard

Disclaimer

Additional Disclaimer: I do not actually know a Hal and Stephanie Brown. They are purely fictional. This fact pattern is not based off of any client’s situation. It is purely fictional. Any similarities to anyone’s situation is coincidental.